Spotify SPOT opened trading today up 4.6% after a mixed earnings results. The stock broke down over 5% from the opening price as investors weighed earnings and management guidance. Spotify reported less than expected EPS results today posting -$0.90 per share vs. the expected -$0.37. Although this was a huge miss, it still narrowed its losses by 11% from Q1 2018. Revenues beat estimates by 3% and illustrated 33% YoY growth, with this top line growth being driven by continued subscriber expansion.

The mismatch of revenue and earnings was partially due to its Google GOOGL Home Mini promotion along with the price reduction associated with its joint promotion of Spotify Premium + Hulu that they offered in the US. Mispricing in ad-related revenue caused underperformance for this segment, but adjustments were made in the final month of this period which is expected to alleviate this underperformance moving forward.

Business Performance and Overview

Spotify just broke 100 million premium subscribers, which was on the high end of guidance. This milestone is a massive success for the firm, making it the first music-streaming company to hit this figure and further proves its ability to attract and retain new customers. Less than half of Spotify’s monthly active users (MAU) are paid premium subscriptions, with 123 million (56%) being ad-supported, but over 90% of the revenue comes from their premium subscription.

Paid subscribers are growing at a faster pace than ad-supported users, and the goal is to transition these ad-supported users to premium paying customers once they become acclimated to the platform. Also 42% of subscription additions to the service were previous users illustrating that “more and more frequently we’re seeing users come back,” according to Barry McCarthy.

Spotify is extending its product offering with considerable additions in their podcast portfolio. In Q1 SPOT acquired Gimlet, Anchor and Parcast for a total of about $500 million. This expansion demonstrates Spotify’s focus on being the #1 audio streaming platform in the world. This segment is expected to grow SPOT’s ad-revenue by a considerable amount but decrease its average revenue per user.

Spotify launched its services in India earlier this quarter and was able to capture over 2 million users. This figure is expected to grow as the brand is more universally recognized. Revenues for this space are going to grow incrementally as ad services are developed and more users become paying customers.

Spotify is the largest music streaming service in the world with its closest competitor being Apple Music AAPL. Spotify captures far more users than Apple Music with 217 million MAU and 100 million paid subscribers compared to Apple’s 56 million paid subscribers. Spotify offers more for users who want to discover new music making it easier for them to navigate through new artists and recommentations that they might be interested in. Using Apple Music, it is much more challenging to discover new artist outside the mainstream considering that their focus is on top hits. Spotify has over 60 million tracks and adds an additional 40,000 daily, making it the go-to platform for up and coming musicians.

As a whole, Spotify has been able to perform at and even above expectations for user growth. With a proliferating growth rate investors don’t expect a positive bottom line as of yet. As long as user & market share growth is consistent and the firm is softening its losses in line with guidance this stock should continue to see growth.

Looking Forward

Management’s forward-looking guidance is showing 21-29% top-line growth with premium subscriptions growing 21-32% year over year for 2019. A bottom line loss is still expected for the year. Even though Spotify hasn’t been able to consistently show profits they have steadily grown their free cash flow (FCF) since it went public and has more than doubled it since Q1 2018. This illustrates efficient cash usage and an ability to be flexible with future investments.

One concern to consider as an investor is the decreasing in average revenue per user (ARPU) that is expected to continue throughout the year. This is due to its increased investment in Podcasts as well as markets abroad which both produce an ARPU below Spotify’s current average rate. None the less if this ARPU continues to fall as they scale this firm may not be able to produce the margins sufficient for profits in the future.

The music-streaming business is fast expanding making up 47% of total music revenue and having grown 34% YoY. This category is only going to expand further as age gaps are broken through (being that most of Spotify's users are under the age of 34) and consumers in foreign markets are captured.

Stock Performance and Recommendation

Spotify has had a rocky road since its direct listing on the New York Stock Exchange on April 4^th 2018. SPOT is down 16.6% from its direct public offering (DPO) price of $165.90. 2019 has turned out to be a stellar year for SPOT investors thus far, with the stock up over 20% beating the market as a whole. The 52-week chart illustrates a much more negative picture with SPOT underperforming as you can see below. SPOT (-15.2%) (blue) vs S&P 500 (10.8%) (red).

Forward price to sales (P/S) is going to be the most useful valuation metric to look at for a growing tech firm with no current profits. SPOT = 3.31x P/S (blue) vs. S&P 500 = 3.2x P/S (red).

As you can see this valuation has come down quite a bit from its original multiple and is now in line with the S&P 500’s current P/S. This could be a buying opportunity for this music-streaming trailblazer if you can stomach a couple more years of negative earnings. SPOT - Zacks Rank #3 (Hold).